How "Hot Money" is Wrecking the U.S. Banking System…

[Editor's Note: The Federal Deposit Insurance Corp. insurance fund that protects your deposits is $20.9 billion in the red. One of every 11 U.S. banks is in trouble. And it's going to get worse. Neither the FDIC, the Federal Reserve nor the Treasury Department will 'fess up that what's fueling bank failures is a risky form of funding called "brokered deposits." Industry insiders refer to them as "hot money." Credit-crisis expert Shah Gilani spent months investigating the often-murky world of hot money. This story is excerpted from an in-depth report, which readers can access by clicking here.]

But the real culprit – the one that regulators won't talk about publicly – is the funding scheme banks employ to load themselves up on speculative loans. T his scheme – far removed from most investor radar screens – has played a major role in the banking sector's growing woes, and will continue to contribute heavily to bank failures in years to come.

The centerpiece to this risky strategy is a funding vehicle known officially as a "brokered deposit." However, due to the narcotic-like effects brokered deposits can have on a bank's balance sheet, industry insiders have adopted a more-appropriate moniker – referring to them as "hot money."

The Birth of "Hot Money"

Brokered deposits have helped banks grow explosively from tame domestic companions into muscular monsters that are capable of ripping the face off of economic prosperity when the lending institutions blow up.

To understand all the forces at play here, we need to look back nearly 50 years.

As far back as the 1960s, depositors searching for high-yielding savings and thrift accounts were matched up by brokers who steered them to banks offering the best yields.

Say, for example, you have $1 million that you want to deposit. A "deposit broker" would take the cash, and break it up into several smaller portions, each of them below the maximum allowed to qualify for federal deposit insurance. Those deposits would be spread among banks that are customers of the broker.

That cash provides the banks with money that they can turn around and lend. And it also provides the Federal Deposit Insurance Corp. with fees for its insurance fund.

But brokered deposits also have a dark side.

Fueled by hot-money deposits, banks too often shift into a turbocharged growth mode. They expand into markets they don't know and concentrate their loans, instead of spreading their risks. When the music stops, as it did in 2008, these banks crash and burn.

As early as 1963, regulators tagged brokered deposits as problematic. They limited any bank's holding of them to only 5% of total deposits. Regulators were worried that upward pressure on interest rates from banks trying to attract depositors would spread across the economy. Later, some brave and stalwart regulators screamed that these deposits were causing bank failures and threatened the entire banking system.

In 1984, William M. Isaac, chairman of the FDIC, personally identified the origins of what would later become the U.S. savings and loan crisis. He railed about how S&Ls and thrifts were paying high yields to attract brokered deposits and using the money to make crazy, speculative loans and bets. He proposed killing the brokered deposits business altogether.

Banks, of course, loved brokered deposits. And they fought hard against the FDIC's initiative to kill the hot-money juggernaut.

Special interest groups were intent on seeing the brokered-deposit business flourish. And they'd already won some extraordinary trophies.

The Deposit Institutions Deregulation and Monetary Control Act of 1980 proved to be their first bonanza. It removed the 5% limit on brokered deposits imposed by regulators in 1963. It phased out a ceiling on the interest rates that banks could pay. And it raised FDIC insurance from $40,000 to $100,000 (in 2008, insurance was raised to $250,000). The 1980 Act was shepherded through Congress by the Carter Administraion. When Donald T. Regan was appointed the U.S. treasury secretary in 1981 by President Ronald Reagan, Regan also became chairman of the Depository Institutions Deregulation Committee, and helped push through the 1982 Garn-St. Germain Act, which furthered the 1980 act.

As fate would have it, Regan came to the Treasury Department from Merrill Lynch, which was one of the biggest players in the brokered-deposit business. Back then, it was Merrill Lynch, not Goldman Sachs Group Inc. (NYSE: GS), running on the Washington inside track.

By 1984, the party was rocking and no one wanted anyone to take away the punch bowl. The FDIC's Isaac was trying to kill off brokered deposits. So was Edwin J. Gray, chairman of the Federal Home Loan Bank Board, which regulated thrifts.

Both were slammed to the mat.

The Securities Industry Association (SIA), a lobbying powerhouse, joined deposit broker First Atlantic Investment Corporation Securities Inc. (FAIC), and sued to repeal the initiative. The duo won a quick victory. FAIC would later have the dubious distinction of having brokered the second-largest amount of deposits into thrifts that would subsequently fail.

A total of 1,043 thrifts failed during the S&L crisis. Taxpayers were stuck with a $124 billion cleanup bill.

The memory of it still haunts Isaac, the former FDIC chairman.

"The record of the 80's is clear," Isaac told me in an interview. "We got flat out opposition from Treasury and Congress refused to back the regulators."

Little has changed since then: Special interests continue to steer us straight at the icebergs.

When Bloomberg Markets magazine asked Seidman about the nature of the company he'd joined, he conceded there would be critics. But he had an answer ready.

"The question can be raised: `Is this what the government wanted when they put in deposit insurance?'" Seidman told his interviewer.

But then he answered his own question by stating that "one man's loophole is another man's God-given right."

Promontory Interfinancial is a rising star in the brokered-deposits business and is also a powerhouse special interest machine. Its list of founders reads like a "Who's Who" of financial-sector regulation, and includes:

· Mark Jacobsen, FDIC chief of staff from 1999-2002.
· Eugene Ludwig, comptroller of the currency from 1993-1998.
· And Alan Blinder, vice chairman of the U.S. Federal Reserve from 1994-1996.

They know how the system works.

I asked Jacobsen, Promontory's co-founder, president and chief operating officer, about creating the firm and what it meant to be in the business. His response: "The fact is, I have a different perspective now than I would when I was a former regulator."

Jacobsen makes an eloquent case for Promontory's business model. Although the firm has a product that mimics traditional brokered deposits, Jacobsen's brainchild is actually a product called the Certificate of Deposit Account Registry Service, or CDARS.

CDARS are "reciprocal deposits." They allow local banks to bring in large depositors who might otherwise shop their funds around through other deposit brokers. The large deposits are broken up through CDARS and spread out across Promontory's member network of nearly 3,000 banks.

The bank receiving the large deposit doesn't miss out. It gets back an equivalent sum in small deposits from the network to use to fund its loan book and assets.

Promontory recently persuaded the FDIC to separate reciprocal deposits out from a calculation of total brokered deposits held by any one bank. Brokered deposits are subject to additional FDIC levies when the agency calculates what a financial institution must pay into the deposit-insurance fund. However, in spite of being statutorily defined as brokered deposits, CDARS won't be counted as such when the FDIC calculates those additional assessments.

This exception isn't lost on other banks, says Sherrill Shaffer, a professor of banking and financial services at the University of Wyoming who is also a former chief economist of the New York Federal Reserve Bank – and a one-time head of the Department of Supervision, Regulation and Credit at the Federal Reserve Bank of Philadelphia.

"When losses go up at the FDIC, premiums (on brokered deposits) go up in the next quarter," Prof. Shaffer said. "So any banks not using CDARS end up cross-subsidizing those that do. To get around that, they have to sign up."

Financial Intrigue – Internet Style

In the brokered-deposit universe, the deepest black hole exists in cyberspace.

A constellation of special interests is pushing brokered-deposit services. The weapon of choice is a powerful device known as "listing services."

Listing services are nothing more than a cyberspace bulletin board where banks that advertise the rates on their certificates of deposits (CDs) can be linked up with consumers or institutions searching the Internet for the highest yields for their savings.

But it's also a gravity-free zone where the mere press of a button can cause "hot money" to jump from one bank to another – effortlessly and instantaneously.

In spite of that reality, listing-service money isn't counted as a brokered deposit. Instead, it's counted as a "core deposit" – which regulators define as a "stable source of funding" for lending.

But here's the reality:

Listing-service deposits are hot-money deposits advertised by banks that have to be rolled over or replaced when CDs mature. Far from being stable, these deposits actually create liquidity issues for banks.

Because they are hot money disguised as core deposits, listing-service deposits can also mask capital-adequacy issues at a bank.

Failing to distinguish between core deposits and hot money makes it tougher to assess risk at banks that accept those deposits.

Because listing services are incorrectly classified – despite their risk – banks don't have to pay the higher deposit-insurance premiums assessed on other hot-money deposits. That means the FDIC isn't paid for the additional risk it's taking on by insuring these higher-risk deposits.

Because listing services are counted as something that they're not, no one really understands the effect of listing-service deposits on bank operations.

The Search for Solutions

The argument over brokered deposits, listing- service deposits and reciprocal deposits is a heated one.

While there may be nothing wrong with the public seeking high yields and government guarantees on their bank deposits, there is something wrong with what banks do with the funds they gather. Of course, there wouldn't be any problems if regulators were doing what they were supposed to be doing, monitoring the risks and growth trajectories of the banks that had funded themselves with hot money.

Advocates and the special interest groups that have protected, proliferated and profited from brokered deposits have a long list of reasons that banks should be permitted to continue their use. What's more, advocates say, it's not the brokered deposits that cause banks to fail: It's bad management of those assets that causes such failures.

The University of Wyoming's Prof. Shaffer sees it this way: "The use of brokered deposits in some cases fund rapid growth, which has its own risks and in some cases substitutes for an outflow of deposits from individual depositors who are becoming concerned about the health of the bank," he said. "In either of those applications, the use of brokered deposits can permit a bank to take on more risk than it otherwise would and that's the main way in which moral hazard arises."

The question to ask is this: Will the use of brokered deposits and other variable-cost and hot-money funding schemes be promoted as part of a policy to attempt to grow our banks out of this crisis?

Hopefully not: That strategy didn't work in the 1980s, didn't work recently, and won't work in the future.

But there may be a way to save us from more boom-to-bust cycles.

What if we took away the inside track of special interests that profit on the backs of taxpayers by insuring all bank deposits? What if we break up all the "too-big-to-fail" banks and spread their pieces around the country to place credit closer to folks on Main Street?

What if we rewarded banks that made good loans and financed jobs, manufacturing, product innovation and productive service industries with tax incentives that they could use to lower the cost of credit to deserving borrowers or pass along to public shareholders? What if we facilitated our banks competing with other global players by making them share and diversify the risks and rewards associated with loan origination, underwriting, securitization and product innovation? What if there wasn't more or less regulation, just effective regulators doing the jobs they were supposed to be doing?

Jacobsen, the former FDIC chief of staff and Promontory co-founder, may have cut to the heart of the issue when he stated that no sweeping fix exists.

"Moral hazard is where the money is," he said.

[Editor's Note: This article is excerpted from Shah Gilani's special investigative report,"The Cold Truth About 'Hot Money:' How Brokered Deposits Became the Third Rail of the American Banking System." Among its revelations, the report presents the inside story on how back-dated accounting allowed IndyMac Bank to keep taking in brokered deposits before it failed, costing the Federal Deposit Insurance Corp. (FDIC) $10.4 billion. It portrays how Ally Bank propped itself up with its TV commercials (if you watch TV, you've seen them) and its Internet grab of brokered deposits.

Gilani, the report's author, is a retired hedge-fund manager who is also a well-known expert on the global credit crisis. In researching this report, Gilani conducted hundreds of interviews — which enabled him to provide insights that just aren't available anywhere else. Check out the entire report. It's available – free of charge – by clicking here.]

Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

Are you being dishonest for a reason? You state, "The 1980 Act was shepherded through Congress by U.S. President Ronald Reagan's new treasury secretary, Donald T. Regan". I checked the Wikipedia reference you gave, and indeed, the act was passed in 1980.

However, Reagan become president in 1981. Democrats controlled congress and the presidency in the years prior (in the case of congress, for decades).

It is difficult to read the remainder of an article such as this. I was interested, but I cannot check all facts. Something as blatant as this, along with the innuendo, suggests you have an objective where truth is not a critical portion.

And the fact that the democrats set up the republicans in another scam by repealing The Glass steagall act Act in 1999. There is a coalition here and or a pattern which the American people need to intellectualize. The two party system is a fascist state designed to usurp the American peoples liberties. Isn't it phenomenal how money can be traded for honesty and integrity even at the expense of "The Great Experiment". The banksters have certainly let the air out of Americas bag.

I am head of public affairs at Promontory Interfinancial Network. The first comment, the one from Jim Brink, pretty well sums up my reaction to this piece, too — it is totally without merit. There are so many mistakes in fact and in interpretation here that you have to assume they are deliberate. It would take far too long to refute the piece point by point, and after the first few examples, no one would care anyway. I need to set the record straight, though, on three quotes. I listened to every conversation between Mark Jacobsen and Mr. Gilani. I never heard Mr. Jacobsen say "The fact is, I have a different perspective now than I would when I was a former regulator" (The fact is, Mr. Jacobsen is still a "former regulator" — once a former regulator, always a former regulator). I never heard Mr. Jacobsen say, "Moral hazard is where the money is." I never heard him say (from the longer report) "wait to see when the tide goes out who has been swimming naked" (though I recognize the line from a speech in the late 1980s or early 1990s by former Comptroller of the Currency Bob Clarke). Hatchet job is the term that comes to mind.

FDIC is the root of the moral hazard. What you are describing is the unintended consequences of the moral hazard legislation. Not mentioned here is the additional hazard of depositors not really caring a whole lot about bank soundness, because, after all, their money is insured.

So we need *more* regulations to manage the side effects. Those regulations, of course, are guaranteed to be free of their own side effects

If you want the end of bank corporatism, you have to get rid of the regulations which were lobbied for those whom benefit from the market distortions. And get rid of the moral hazards and unintended consequences. Oh, that and, when a business screws up, they need to go out of business, and not be rewarded for their errors by a government bailout paid for by the rest of us.

What am I missing here? If you got rid of the brokers of hot money, wouldn't the depositor just spread his deposits around the different banks himself in order to stay under the FDIC protection limit? Aren't these brokers just providing a convenient service for the depositor so that he doesn't have to have 20 different accounts in order to remain FDIC insured?
I fail to see how any of this "hot money" business is relevant. The banks would still have the same liability whether the depositor deposits directly to the bank, or through a broker.

Despite the criticisms of this article, which may or may not be fair or accurate, i found this description of hot money and brokered deposits not just interesting, but rather eye-opening. I had actually never even heard these terms described before, though I have heard both terms used by writers who never actually described what these terms meant. This article suggests or implies that all this hot money is really the root cause, or one of the major root causes, of our current economic crisis. If so, it is my opinion that this crisis may well re-emerge from time to time, ever bigger and ever more dangerous, until it finally brings down tha nation's, and perhaps the world's, financial system, precisely because those who use these financial mechanisms and devices will fight to continue to use them, and will make it ever more difficult for any Congress or President or regulator to put a stop to the over use of these. thus, as the nation's and the world's financial systems become ever more massive and complex, these basic mechanisms may well ultimately bring down the whole house of cards. Dear author, forget the criticisms, and try hard to make this kind of information widely available to the general public… perhaps someday, they will realize that the US banking system MUST be rigorously and strictly regulated, instead of being run by self interested bankers and others who may destroy the system by taking too great advantage of it.

It is unfortunate that Gilani's article may not be totally accurate relative to who said what/when.
I was a privately owned mortgage banker in the 1980's and observed first hand how many of
the S&L's used brokered deposits in a variety of risky ventures in an attempt to save them
selves.Much the same as a person drowning grabs for anything floating.The current situation
with many of our banks is the same.They will and do engage in most any approach to try and
save themselves.The fed is assisting them by maintaining rates at artifical levels thereby
providing the carry trade.The substance of Gilani's article is that the use of "hot money"
is the fuel for the carry trade and we don't know what octane the banks are buying nor
what size engine they are going to put it in.I am a believer in the "real' free market system
and would like to avoid regulation when ever possible but banks are quasi-private
institutions utilizing government insurance and to not regulate how they get their 'juice'
and subsequently how they use it is asking for a train wreck.

Gentleman,
Lets get some things straight here. What we are now experiencing are the after effects of deregulation and increased spending on the part of the controlling political party without an requisite increase in taxes. In my opinion, his started in the Reagan years and went through Bush I and Bush II when the party in control cut taxes to some of the wealthiest people in the country, while repeatedly increasing spending. Now we are faced with many of the same consequenses that the Hoover Administration faced from 1929 until they where voted out of office in 1932. However, because of the massive increase in the deficit during these three administrations, we now find outselves in an even worse situation because of our incredible indebitedness. Now we are faced with the "Perfect Storm". Argue as we might, the only way that we are going to get out of this mess is by increasing taxes to pay off the unfunded liabilities that built up during the above three administrations. If anybody that reads this forum thinks that we can cut Social Security, Medicare and Medicade, I've got some swamp land to sell them. Gentleman, in my opinion, the above administrations let the financial wolves loose through deregulation and now we have a mess. That, in my opinion, is why the American voters removed the majority party from power in 2008, just as they did in 1932. Mr. Gilani's points are well made. We are now going to go back into a period of reregulation and many of the financial wolves are going to be investigated and possibly prosecuted, just as many where during the firestorm that followed the crash of 1929 and the Great Depression. Hopefully, a new generation of leaders will emerge that can sort out this mess and once again get this country back on a path to financial prosperity as happened from basically 1935 until the "deregulators" returned to office in the 1980's.

At first I was skeptical, but managed to hold it at bay. When I got to the Reagan and Regan thing my skepticism won the day. Three minutes of Googling confirms what others have already found: The bill was signed by Jimmy Carter on March 31, 1980, while Ronald Reagan was still running for president in his first election, and Don Regan was busy running Merrill. With such a glaring error I didn't bother to read any further and skipped to the comments.

Mr. Brink, thank you for your comment. You are correct that the 1980 act was passed during the Carter administration. However, Don Regan did help push through the act, as it was in Merrill's interest as well as in the interests of all the S&Ls and thrifts. When Regan became Treasury Secretary in 1981 he also became Chairman of the Depository Institutions Deregulation Committee, and helped push through the 1982 Garn-St. Germain Act, which furthered the 1980 act. As Ronald Reagan's champion of deregulation, Regan pushed the envelope wherever he could. Almost all legislation results in "unintended consequences". When it became obvious that brokered deposits were fueling a banking crisis, one would think it incumbent upon the Treasury Secretary to listen to the regulators who were charged with regulating institutions that were threatening the insurance funds they were responsible for. Instead, he crushed all attempts to rein in brokered deposits which resulted in the collapse of the over 1000 institutions and cost taxpayers over $124 billion. I do not point blame at Republicans or Democrats, both parties pass legislation as a result of special interest groups pressing and paying for their narrow agendas. I am a free market advocate. However, when unintended consequences threaten the safety of the banking system, capital markets, the economy and the interests of the American public, I think the greater good of the public should always take precedence over the interests of profiteers. It's not about more or less regulation. It's about effective regulators doing there jobs. If the powers that be want effective regulation, they get it; if they are against effective regulation, they determine the effectiveness of those who answer to them. There are fingers to be pointed at both Democrats and Republicans for poor legislation and not addressing the unintended consequences of what results from their laws.

As for Mr. Battey's comments, I thank both he and Mr. Jacobsen for the extensive and enlightening interviews they granted me, and for their allowing me to record those conversations. I stand by the quotes attributed to Mr. Jacobsen. However, the quote regarding seeing who is swimming naked when the tide goes out was not attributed to Mr. Jacobsen. It was a comment that Warren Buffet made when he was asked about who might be in trouble as a result of the credit crisis.

In your response to the challenge that the Deposit Institutions Deregulation and Monetary Control Act of 1980 was passed during the Carter administration, not the Reagan, you said:
"You are correct that the 1980 act was passed during the Carter administration. However, Don Regan did help push through the act, as it was in Merrill’s interest as well as in the interests of all the S&Ls and thrifts." Please explain how Don Regan had any position or power to push this through while Carter was president. Was this in the capacity of a lobbyist?

Capital shifted to hot markets that couldn't generate it themselves – higher interest rates paid, must push it out the door, make all possible loans. Everything is insured – who cares what your money does when you aren't looking. How much outside money is too much? What percent? Situationally we'll know – after the fact. Can't tolerate any arbitrary ounce of prevention number that limits speculation and protects savers at large.

It is the FDIC insurance that is the fundemental driver. There is a saying here in UK "Governments should never throw money at a problem that the do not want to see increase." Sadly the UK administration frequently demonstrates the truth of this but rarely learns the lesson.

Without a Federal back stop S&Ls would have to buy insurance against their loans going sour on the open market. With AIG around I cannot be positive the price charged would have reflected the risk, but I suspect it would have been closer. I also believe the shutters would have come down much sooner on the sub-prime market.

Cheap money is the Fed's responsibility and the existence of it can be blamed on political imperatives. The Bank Rate (as the equivalent of the Feds rate is called here) was the same at 5% for 200 years! Arguably the most successful 200 years in Britain's history. That is a good clue as to the normal rate for central bank's loans and no country will be back on the right track until it has that rate again.

Because cheap money does not help sound businesses grow, it just helps them make more profits. Cheap money makes bad businesses grow and helps postpone their deserved failure.

Thank you Mr. Gilani for an insight we lay folks rarely receive. Despite any real or perceived errors in the article, several truths are exposed. Free markets are less and less free as government grows and grows. Moral hazard is always backed by the innocent taxpayers who are being duped twice; by the original transaction in good faith and the last transaction in good fear. Neither the banks nor politicians face the consequences of their failed intended actions while the taxpayer faces the unintentional consequences of trusting the fascist and unholy alliance of business and government. The only true solution is not more regulators nor more effective regulators but breaking the unholy alliance that stealthily creates tyranny from the culture of justice found only in liberty.

We were interviewed during Shah's investigative process. An interesting thing I found was he spent 13 1/2 pages berating brokered deposits and one of his last statements is brokered deposits weren't the problem. You certainly wouldn't come to that conclusion without reading the whole article.

For the record, we are one of those companies that acts like a rate service. And I am one of those that don't believe the deposit itself is the problem, but what is done with it. Yes, a large number of banks that have failed had brokered deposits, but also a large number of them had less then 10%. Also interestingly, many of them basically stopped taking brokered deposits, but then they slid downhill even faster.

From the banks perspective, brokered and rate service deposits are often in larger denominations, less costly, from Patriot Act exempt depositors, and much more efficient. Of course because of their nature, you don't want a large percentage of them, that could cause some serious liquidity problems.

From the investors perspective, using a rate service or broker is very efficient. They can make a few phone calls, a few wires and have all of their funds placed and insured. When a client has millions of dollars to place, they often don't have the time, nor the resources to do it all locally. The assault on brokered deposits, bank bailouts, and attempts at regulations have actually cost them large sums of money. Ask an institutional investor what kind of rate they are getting for a 1-year CD. It will probably make you cry.

I don't think making all deposits insured is the answer, that would certainly cause growth problems. I do believe a banks growth should be tied to their long-term success and what they are doing on the other side of the balance sheet. New banks would have to grow slowly. Older, successful banks would be rewarded. A bank making extremely risky loans, wouldn't be allowed to grow that beyond certain limits. In reality you would think banks would want smart regulations, because it is their premiums that are being increased to cover for the other banks' greed.

I also believe if brokered deposits are going to be assessed, then all non-core deposits should be assessed. A shadow system of "hiding" them isn't helpful either. One group shouldn't be favored over another just because of their lobbying efforts.

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